Do Insurance-Linked Securities Hold the Key to London’s Reinsurance Success?

The UK’s insurance industry could get a much needed boost if the British Treasury gets its way with insurance-linked securities (ILS). ILS is currently among the fastest growing sectors of the market and capturing its share could help the UK remain a reinsurance hub. However, to capitalise on ILS, we need a new regulatory and tax framework. According to economic secretary Simon Kirby, the UK doesn’t currently have frameworks that will allow it to compete in the international ILS market.

The Treasury has now published its draft proposals for the framework consultation. Consultations are open until 23 February 2017. Consultations are also open for plans for authorising and supervising insurance special purpose vehicles (ISPVs), which will regulate activity of insurance risk transformation. Consultations are open until 18 January 2017.

What are insurance-linked securities?

Insurance-linked securities give insurers a chance to cut out the middle man (reinsurers) by transferring risks to capital markets. They’re used most often to mitigate ‘catastrophic risks’ from natural disasters. The ILS market has grown significantly and now comprises an estimated 12% of the reinsurance market.

The market is expected to continue delivering outstanding returns. If the ILS market holds steady, it has the potential to yield returns of over 8.5% per year.

Good timing?

Brexit – it could be the word of the year in this part of the world. It could potentially affect everything. Insurers are particularly concerned about how Brexit will affect the market. If the proposed regulatory changes are carried out, however, ILS could not only prevent a decline, they could also boost London’s position globally. Several high-flying, influential financial experts are optimistic about insurance-linked securities. For example, Michael Wade, senior advisor to the Cabinet Office, has said that they could be a game-changer for London.

The plan

Insurance-linked securities have been a long time coming, with the intention to change frameworks announced in 2015. We’re now in the final consultations phase, so what will happen if everything goes according to plan?

Well, the ISPVs will be managed by the Prudential Regulation Authority (PRA) and they will use a protected cell company (PCC) corporate structure. One of the reasons for this is that English Law already recognises PPC corporate structure. Another reason is the ability to segregate assets and liabilities in accordance with the Solvency II regulatory framework. And, the system is efficient with a single ISPV able to manage multiple deals.

ILS will fall under a bespoke tax regime and won’t be subject to corporation tax. Foreign investors will benefit from a withholding tax exemption but UK investors will be taxed according to their facts and circumstance.

ISPVs will remain under dual-regulation, but will need to submit applications for authorisation for the new regulated insurance risk transformation. The PRA and Fiancial Conduct Authority (FCA) estimate a 6 to 8-week application-processing timeframe.

Look to the future

In addition to covering catastrophe risks, Nick Bradley of Pinsent Masons says that insurance-linked securities will also be used to cover various life insurance associated risks, including mortality and morbidity risk.

Bradley said, “The Treasury, the Bank of England and the regulators deserve credit for recognising the opportunity, and hopefully this exciting initiative will enable UK PLC to put in place an effective regime which is both attractive to investors and reinsurers.”